We’ve introduced the basics of Venture Capital and there’s a few key points: it’s an asset class with impressive return potential, substantial risk and in the unlisted arena the Early Stage Venture Capital Limited Partnership (ESVCLP) is one vehicle designed to allow regular investors to access Venture Capital.

 

However, while VC is on the rise in Australia, thanks to generous tax concessions from the federal government ($) (among other things); it’s an asset class that has faced substantial criticism in the recent past.  The Kauffman foundation raised some serious questions about the asset class (at the institutional level in the United States) in 2013.

 

Small or micro cap investment (investing in publically listed companies with small or micro-size capitalizations) is sometimes touted as an alternative to venture capital in the belief that it can manage some of the less palatable aspects of venture capital: the high level of risk, the fees, long investment horizons and liquidity. The two investment types do have some similarities:

  • Both are looking for companies with growth or expansion potential.
  • Both are subject to high levels of risk.
  • Both have speculative aspects to them and rely on the investors’ judgement.

 

There are some pretty important differences between the two, however:

  • If you’re investing in small or micro-caps directly, you don’t pay fees to a fund manager (though you will pay brokerage fees for your trades). Given that performance fees for venture capital are commonly in the range of 20%, plus management fees, this can be a substantial amount.
  • In a VC partnership, you are relying on the experience, knowledge and contacts of the managing team. Their thesis is that they add value by collecting and analysing information in a manner and volume that a regular investor cannot; while also providing value to the investee company through mentoring or business support. The value-add thesis runs two ways in a VC partnership: the manager shares her information with you and locates a profitable investment. The manager also shares her information with the investee to boost that investment. If you are investing in small or micro-cap independently, you’re doing without that support and are investing a lot more of your own time researching companies.
  • Liquidity is a hot-button issue for many people and it’s true that an investment in an exchange listed company can be bought or sold at any time: provided you’re prepared to do so at the price the market is asking. If you don’t like the management of the company, you can vote with your feet. In a typical ESVCLP, this isn’t the case: the fund runs for a pre-specified length of time before you can access your money. While this seems like a substantial advantage for small-caps, bear in mind that liquidity isn’t just about opportunity to realise in this context. It’s also about the willingness of another party to make that exchange and allow you to realise your investment. Many small- and micro-caps trade with low levels of liquidity and this can vary over time. This piece at Morningstar, written in 2009, describes what can happen to small cap liquidity in a tight market and is worth a read. In short: the liquidity question isn’t a simple one and needs to be considered carefully.
  • Market-based volatility is a critical issue in small- and micro-caps, whereas an unlisted vehicle like a partnership isn’t exposed to this kind of market-driven valuation volatility. That isn’t to say that unlisted vehicles aren’t exposed to volatility: but measurement of net asset value isn’t measured by market forces on an exchange.
  • Diversification is a critical issue: a single micro-cap held on its own is not a diversified investment: you may need to hold a considerable parcel of stocks to diversify appropriately. However, don’t assume a partnership is necessarily a diversified investment on its own, either. While it may hold a number of investments in the portfolio: is it in one sector or a diverse selection of them? This is different in each partnership, so be aware of the partnership’s portfolio and strategy and make your decisions accordingly.

 

While small and micro-cap investing can be an alternative to VC, there is no clear-cut case as to which may be better for you. It’s entirely dependent on your investment objectives, personal skills, appetite for risk (including risk-type preference) and investment horizons.